Why I Stopped Out Of My Euro Short

Feb. 5, 2012 8:41 PM ET

I have not suddenly fallen in love with the garlic eaters and the beer drinkers, and they certainly are not about to kiss and make up. But I have to respect the harsh judgment of the market. The collapse of the Euro has not been cancelled, just postponed.

Immediately after I sold the Euro short around $1.29 against the dollar a month ago, I got the immediate gratification that I usually expect from these sorts of trades, the beleaguered currency dropping to $1.26. That took the leveraged short Euro ETF (NYSEARCA:EUO) up nicely from my cost at $20.73 to $21.30, generating a profit of 0.70%. I then made the mistake of not taking the money and running.

Since then, the Euro has rallied six cents against the greenback, taking it as high as $1.3220, which is quite a large move in the foreign exchange markets. We went through my $19.50 stop for the (EUO) once a week ago, but I doubted its sincerity and held off pulling the trigger.

When I saw the Euro taking a second run at the highs in Singapore last night, I decided to get a second opinion. I dusted off my antiquated High German, which I learned in Berlin in the 1960's, and called an old friend at the European Central Bank headquarters in Frankfurt to get his read.

The ECB is meeting next week to decide if they will cut interest rates. The case for a 25 basis point cut is overwhelming, based purely on economic fundamentals. But no one ever got rich underestimating the stupidity of European central bankers, who seem to be using a dog-eared and heavily worn playbook they pilfered from Ben Bernanke.

So it is a coin toss whether we will see lower rates next week or not. If they do cut rates the Euro will fall back down to the 2012 lows at $1.26, and maybe more. If they don't, then it could rally as high as $1.35. Absolutely nobody is buying the Euro here. The entire recent move was caused by short covering alone. Yet, the total size of the market short has risen to another all-time high. The CME is showing 170,000 contracts short, worth $17 billion. That is not counting shorts in the interbank market, which could be far larger.

I am reminded of that old quote from baseball legend, Yogi Berra: "Nobody ever goes there anymore because it's too crowded". With shorts this large, it would be easy to see a squeeze continuing. The Euro got a nice tailwind from the global "RISK ON" rally that commenced this year. Modest progress on the Greek debt negotiations provided a further assist. A stealth QE3 from Europe provided even more juice.

I am not in the business of making 50:50 bets. I much prefer 80:20 bets or 90:10 bets in my favor. I don't want to get into a position where many hedge funds found themselves for the first four months of last year, fighting their Euro shorts tooth and nail, while the European fundamentals were rolling over like the Bismarck. When the risk/reward changes, I change. So it's auf wiedersehen baby for the (EUO). My total loss on the position is a modest 1.56%, which works out to $1,560 dollars for my notional $100,000 portfolio. I'll live.

It could be that I just stopped out at the top of the entire move. That happens with stops sometimes. If that is the case, get over it. If you can't stand the heat, get out of the kitchen. Maybe you should consider another line of work. I understand there are wonderful opportunities in mining in western Australia, and there certainly is a shortage of computer programmers here in Silicon Valley.

The smart play here is to let a squeeze continue on up to $1.35, and then re-enter, not through the (EUO), but through put options on the (NYSEARCA:FXY). That would give you much more bang per buck at a better entry point, in a better risk limiting instrument, with a much better risk reward ratio.